1-2-3 Strategy GOAL To recognize and confirm a 1-2-3 formation on a chart (which indicates that a possible change in trend direction has occurred), so that we can enter a new market move early and therefore benefit from as much of the move as possible. SUMMARY This is a trend-reversal strategy that uses specific signals on the chart to spot major market tops and bottoms. We look for a daily price chart of a futures market that has just made its highest or lowest price for the past 12 months (or if the contract has traded for less than 12 months we ll use the life-of-contract high or low, as long as the market has traded for at least six months. Otherwise we ll look for another opportunity). Then we wait for a 1-2-3 formation (explained in the next section) to shape up, indicating that the trend has reversed. Finally, we confirm the trend reversal using Trend Seeker. Once the trend reversal is confirmed, we re ready to purchase options in the direction of the new trend. Remember - for examples of current trades using this strategy see Jim s Chart Book as well as our Premium Alert Service Videos. CHAPTER ONE STEP-BY-STEP INSTRUCTIONS 1 Every commodity has only one highest point and one lowest point during a 12-month period (or if the contract has traded for less than 12 months we ll use the life-of-contract high or low, as long as the market has traded for at least six months. Otherwise we ll look for another opportunity). We call this point the #1 top or #1 bottom respectively. Using the Interactive Chart Feature on US Charts Online, go through the daily price charts to find those markets that are making new #1 tops or bottoms. For our example we ll use a chart of the December 2007 Cotton market. Notice that it s making a new #1 top point. We ve marked it on the chart.
Note: To ensure you re seeing as much historical data on the chart as you need, scroll below the chart, select the 1024 x 768 (large) option, and click the Resize This Chart button. [Chart: December 2007 Cotton thru July 20, 2007] 2 Go back periodically to see how prices are progressing. We re waiting to see a 1-2-3 formation develop (in this case, a 1-2-3 top formation). The formation begins with the #1 top point. Then watch for prices to fall below the #1 point, and again rise (leaving behind a #2 point). As the rise from the #2 point approaches or equals - but never exceeds - the #1 point, and then prices turn around again, a #3 point is formed. Now the 1-2-3 top is completed. A 1-2-3 bottom formation is the mirror image of the top formation. We watch for prices to rise above the #1 point, and again fall (leaving behind a #2 point). As the fall from the #2 point approaches or equals - but never exceeds - the #1 point, and a turnaround occurs, a #3 point is formed. [Simple 1-2-3 Top and Bottom Schematics]
3 While a bottom or top formation can signal the turnaround of a trend, there may be numerous 1 and 2 points made as a market falls or rises. We don t want to enter the market in the direction of the new trend until a genuine 1-2-3 formation has been confirmed. Our first confirmation is a breakout of prices above (for a bottom formation) or below (for a top formation) the #2 point. Here again, however, a false breakout can lead to a brief move followed by a continuation of the old trend. Fortunately, we have help in determining whether the breakout is genuine (and the trend actually has reversed) from Trend Seeker (TS). When TS indicates a change in trend (i.e., a Down Trend Rating changes to an Up Trend Rating, or vice versa) we can have more confidence that the trend has in fact reversed. [1-2-3 Top and Bottom schematics with multiple #1 points] 4 The day after TS confirms the breakout of the #2 point and the reversal of the trend, we purchase an option that meets our budget. If prices break above the #2 point of a bottom formation we purchase a call option; if they break below the #2 point of a top formation we purchase a put option. In either case we re entering the market at the beginning of a new trend. Look at the chart of December Cotton on August 9, the day prices broke below the #2 point of the top formation. Checking TS on that same day we find that one day earlier the Trend had changed from Up to Down. Therefore both criteria for entering this trade were met on August 9: the #2 point was broken and the trend had changed to the new direction on TS. The next day, August 10, is when we would purchase our put option. Note: The TS rating can change before, after, or even on the same day as prices break the #2 point. Your signal to enter the trade is when both criteria are met.
[Sample Trend Seeker page screen shot] [Chart of December Cotton thru Aug 10]
5 To find a put option, go to the Option Quotes page of US Charts Online and select the market and month you wish to trade. Choose an option that has at least 90 days before its expiration. For our example, we would choose an option in the December contract. We re looking at the chart in mid- August, and December options give us just about 90 days before expiring on November 9, 2007. The screen shot below shows a sampling of available options in the December Cotton market on August 10. Purchase a put option that is as close to being in the money as you can afford. In this example, let s say we decide to purchase the 60 put for 2.07 points ($1,035). We enter the trade into Trade Tracker to follow its progress. [Screen shot of option table]
[Screen shot of Trade Tracker] 6 Continue watching the charts and wait for your signal to exit that trade (See Possible Exit Strategies below). CHAPTER TWO POSSIBLE EXIT STRATEGIES In a Market Moving in Our Favor This exit strategy is based on using points of support and resistance as they naturally develop and/ or a break in the trend line on the daily chart we re trading. We watch our charts each day. In the case of a call option in a rising market, each day futures prices will rise and possibly fall, but overall the direction will be up, with falling prices hitting a floor that they can t seem to break below. This floor is support. When this support level is broken by a price that does fall below it, we liquidate the option. In the case of a put option, futures prices generally fall, and even when they rise, seem unable to rise above a ceiling, which is resistance. When this resistance level is broken by prices rising above it, we liquidate the option. Another way to select an exit point is to continue to follow TS. When TS indicates that the trend has changed direction, we might consider liquidating our option. Note: Selecting exit points is a highly individual process. Traders may use daily, weekly, or monthly charts to find exit points, and they may read their charts differently. The best way to determine the approach you prefer is to paper trade as many trades as possible.
In a Market Moving Against Us The best exit strategy here is simply to decide upon a dollar amount that we re willing to risk, and if the premium of our option falls farther than that amount, liquidate it. CHAPTER THREE SAMPLE TRADE Let s look at our hypothetical December Cotton trade to see how it might have turned out. Look at the chart of the market as of August 16, 2007. As you can see prices dropped precipitously after our entry on August 10. We might have set our first profit target at 58, a point of strong support on the daily chart. We might have liquidated on August 16, when prices surpassed our target. On that day the option premium was 4.52 points ($2,260), $1,225 more than the premium on August 10. That s an ROI of 84% in less than a week (not including exchange fees or commissions). [Chart: December Cotton thru August 16] Notice: Hypothetical or simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since the trades have not actually been executed, the results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Hypothetical trading results are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown.
CHAPTER FOUR POSSIBLE ADVANTAGES OF THIS STRATEGY By trading with options rather than futures contracts we can limit the amount at risk in a trade to the amount of the premium plus commission. This strategy is easy to follow and doesn t require much time each day to carry out. By incorporating Trend Seeker in making our decision to enter the market, we are helped to avoid entering the market on a false breakout. Look at the following chart of March 2007 Soybeans as an example of how TS would have prevented us from entering the market too soon on a false 1-2-3 top formation. [Chart of March 2007 Soybeans]
CHAPTER FIVE POSSIBLE DRAWBACKS 1 Since we re purchasing options close to the money, these options will tend to be more expensive. 2 We may have to monitor markets for some time before a breakout of a 1-2-3 top or bottom occurs. 3 Even though we re using 1-2-3 top or bottom formations in conjunction with Trend Seeker in finding our entry points, there is no guarantee that the reversal in trend will hold. Watch the trade closely. Remember - for examples of current trades using this strategy see Jim s Chart Book as well as our Premium Alert Service Videos. Special Note : Our advanced How to Master the Charts Video Series offers a video CD on 1-2-3 Top Formations. For a more complete description of the video CD and ordering information, click this link or call a Course Counselor at 1-800-230-2427 Monday through Friday, 8:30 am to 5 pm Pacific Time.